Defined Benefit Versus Defined Contribution Pension Plans: What Are the Real Trade-Offs?
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This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Pensions in the U.S. Economy Volume Author/Editor: Zvi Bodie, John B. Shoven, and David A. Wise, eds. Volume Publisher: University of Chicago Press Volume ISBN: 0-226-06285-6 Volume URL: http://www.nber.org/books/bodi88-1 Publication Date: 1988 Chapter Title: Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-offs? Chapter Author: Zvi Bodie, Alan J. Marcus, Robert C. Merton Chapter URL: http://www.nber.org/chapters/c6047 Chapter pages in book: (p. 139 - 162) 5 Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-offs? Zvi Bodie, Alan J. Marcus, and Robert C. Merton Although employer pension programs vary in design, they are usually classified into two broad types: defined contribution and defined ben- efit. These two categories are distinguished in the law under ERISA. Under a defined contribution (DC) plan each employee has an account into which the employer and, if it is a contributory plan, the employee make regular contributions. Benefit levels depend on the total contri- butions and investment earnings of the accumulation in the account. Often the employee has some choice regarding the type of assets in which the accumulation is invested and can easily find out what its value is at any time. Defined contribution plans are, in effect, tax- deferred savings accounts in trust for the employees, and they are by definition fully funded. They are therefore not of much concern to government regulators and are not covered by Pension Benefit Guar- antee Corporation (PBGC) insurance. In a defined benefit (DB) plan the employee’s pension benefit entitle- ment is determined by a formula which takes into account years of service for the employer and, in most cases, wages or salary. Many defined benefit formulas also take into account the Social Security benefits to which an employee is entitled. These are the so-called in- tegrated plans. See Merton, Bodie, and Marcus (1987) for a discussion of integration. Zvi Bodie is professor of finance and economics at the School of Management, Boston University, and a research associate of the National Bureau of Economic Research. Alan J. Marcus is associate professor of finance and economics at the School of Management, Boston University, and a faculty research fellow of the National Bureau of Economic Research. Robert C. Merton is J. C. Penney Professor of Management at the Sloan School of Management, Massachusetts Institute of Technology, and a research associate of the National Bureau of Economic Research. 139 140 Zvi BodieIAlan J. MarcusIRobert C. Merton DB and DC plans have significantly different characteristics with respect to the risks faced by employers and employees, the sensitivity of benefits to inflation, the flexibility of funding, and the importance of governmental supervision. Our objective in this paper is to examine the trade-offs involved in the choice between DB and DC plans. In section 5.1, we briefly review the mechanics governing the de- termination and valuation of the benefit streams under DB and DC pension plans. Section 5.2 contains an informal discussion of the rel- ative advantages of each type of plan. In section 5.3 we develop a formal model to examine the trade-offs between the two types of plans in the face of both wage and interest rate uncertainty. Our conclusion is that neither plan can be said to wholly dominate the other from the perspective of employee welfare. Section 5.4 summarizes our results and concludes the paper. 5.1 Plan Characteristics and Valuation 5.1.1 Defined Contribution Plans The DC arrangement is the conceptually simpler retirement plan. The employer, and sometimes also the employee, make regular con- tributions into the employee's retirement account. The contributions are usually specified as a predetermined fraction of salary, although that fraction need not be constant over the course of a career.' Contributions from both parties are tax-deductible,* and investment income accrues tax-free. Often the employee is given a choice as to how his account is to be invested. In principle, contributions may be invested in any security, although in practice most plans limit invest- ment options to various bond, stock, and money-market funds. At retirement, the employee either receives a lump sum or an annuity, the size of which depends upon the accumulated value of the funds in the retirement account. The employee thus bears all of the investment risk; the retirement account is by definition fully funded, and the firm has no obligation beyond making its periodic contribution. Valuation of the DC plan is straightforward: simply measure the market value of the assets held in the retirement account. However, as a guide for personal financial planning, the DC plan sponsor often provides workers with the indicated size of a life annuity starting at retirement age that could be purchased now with the accumulation in their account under different scenarios. The actual size of the retire- ment annuity will, of course, depend upon the realized investment performance of the retirement fund, the interest rate at retirement, and the ultimate wage path of the employee. 141 Defined Benefit versus Defined Contribution Pension Plans 5.1.2 Defined Benefit Plans Whereas the DC framework focuses on the value of the assets cur- rently endowing a retirement account, the DB plan focuses on theflow of benefits which the individual will receive upon retirement. A typical DB plan determines the employee’s benefit as a function of both years of service and wage history. As a representative plan, consider one in which the employee receives 1 percent of average salary (during the last 5 years of service) times the number of years of service. Normal retirement age is 65, there are no early retirement options, death or disability benefits, and no Social Security offset provisions. The actuarially expected life span at retirement is 80 years. Assuming the worker is fully vested, at any point in time his claim is a deferred nominal life annuity, insured up to certain limits by the Pension Benefit Guarantee Corporation. It is a deferred annuity because the employee cannot start receiving benefits until he reaches age 65. It is nominal because the retirement benefit, which the employer is contractually bound to pay the employee, is fixed in dollar amount at any point in time up to and including retirement age. Many people think that under final average pay plans of the sort described here, retirement benefits are implicitly indexed to inflation, at least during the employee’s active years with the firm, and therefore should not be viewed as a purely nominal asset by the employee and a purely nominal liability by the firm. We examine this issue in detail in section 5.2. For now we focus on the value of the explicit claim only. Given an interest rate and a wage profile, it is straightforward to compute the present value of accrued benefits under our prototype DB plan. Table 5.1 presents such values for workers at different ages as- suming a constant real annual wage of $15,000. The present value of accrued liabilities can increase from continued service because of 3 factors: (1) as years of service increase, so does the defined benefit, (2) if the wage increases, so will the retirement benefit, and (3) as time passes, less time remains until the retirement benefits begin, SO that their present value increases at the rate of interest. To illustrate the separate contributions of each of these factors to the cumulative results reported in table 5.1, consider the case in which the benefit formula calls for 1 percent of final year’s salary times years of service and that the worker lives for 15 years after retiring at age 65. The worker is 35 years old, has worked for the firm 10 years, and his current salary is $15,000. The nominal interest rate equals a real rate of 3 percent per year plus the expected rate of inflation. Under the 7 percent inflation scenario, the sources of the change in the value of the pension benefit from the passage of an additional year are as follows. Prior to this year, the worker had accrued a life annuity Table 5.1 Present Value of Accrued Benefits and Marginal Change in Benefits for Hypothetical Worker, No Early Retirement Marginal Change in Present Value of Present Value of Accrued Benefits from Accrued Benefits an Additional in Constant Dollars Year’s Work 0% Inflation 7% Inflation 0% Inflation 7% Inflation 3% Discount 10% Discount 3% Discount 10% Discount Rate Rate Rate Rate Starting Age 25 Constant % of Constant % of Current Age Dollars Salary Dollars Salary 30 $2,274 $144 $455 3.03 $4 1 .27 35 $5,271 $463 $527 3.51 $82 .55 40 $9,167 $1,120 $61 1 4.07 $158 1.05 45 $14,169 $2,404 $708 4.72 $297 1.98 50 $20,532 $4,840 $82 1 5.47 $546 3.64 55 $28,563 $9,354 $952 6.35 $938 6.25 60 $38,63 1 $17,575 $1,104 7.36 $1,768 11.79 65 $51,181 $32,329 $1,242* 8.28 $2,794* 18.63 NOTES:Worker currently paid $15,000 per year with no real wage growth. Worker will retire at age 65. Pension plan pays 1 percent of average salary in last 5 years times years of service. Pension plan contains no early retirement provisions or makes correct actuarial adjustment for early retirees. Benefits are vested after 5 years.